Asymmetric Behaviour of Inflation around the Target in Inflation‐Targeting Countries
| Date | 01 November 2015 |
| DOI | http://doi.org/10.1111/sjpe.12089 |
| Published date | 01 November 2015 |
| Author | Kurmaş Akdoğan |
ASYMMETRIC BEHAVIOUR OF INFLA-
TION AROUND THE TARGET IN
INFLATION-TARGETING COUNTRIES
Kurmas
ßAkdo
gan*
ABSTRACT
We explore the asymmetric behaviour of inflation around the target level for
inflation-targeting countries. The first rationale behind this asymmetry is the
asymmetric policy response of the central bank around the target. Central banks
could have a stronger bias towards overshooting rather than undershooting the
inflation target. Consequently, the policy response would be stronger once the
inflation jumps above the target, compared to a negative deviation. Second ratio-
nale is the asymmetric inflation persistence. We suggest that recently developed
Asymmetric Exponential Smooth Transition Autoregressive (AESTAR) model
provides a convenient framework to capture the asymmetric behaviour of infla-
tion driven by these two effects. We further conduct an out-of-sample forecasting
exercise and show that the predictive power of AESTAR model for inflation is
high for some countries in our sample, especially at long-horizons.
II
NTRODUCTION
The last two decades revealed adoption of inflation-targeting (IT) regime by
central banks of numerous developed countries and emerging markets. The
forward-looking nature of the IT regime calls for a rich information set of
robust indicators and reliable inflation forecasts for policymakers. Accord-
ingly, many inflation-targeting central banks aim to improve their forecasting
ability through employing alternative approaches including econometric mod-
els as well as expert judgements.
1
This article contributes to this literature by
showing that the recently developed Asymmetric Exponential Smooth Transi-
tion Autoregressive (AESTAR) model (Sollis, 2009) can capture the asymmet-
ric behaviour of inflation against deviations from a pre-determined target level
in an IT framework. Conducting an empirical analysis covering nineteen IT
countries, we further show that the performance of this model for predicting
inflation is high, especially at long-horizons, for some countries in our sample.
*Central Bank of the Republic of Turkey
1
See Andersson and L€
of (2007) for Riksbank, Kapetanios et al. (2008) for Bank of Eng-
land, Bjørnland et al. (2008) for Norges Bank and €
O
g€
unc
ßet al. (2013) for Central Bank of
the Republic of Turkey.
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12089, Vol. 62, No. 5, November 2015
©2015 Scottish Economic Society.
486
The asymmetric behaviour of inflation captured by AESTAR model is
explicated by two rationales affecting the adjustment towards policy target.
First one is the asymmetric response of the policymaker against upwards or
downwards deviations of inflation from a pre-determined target level (or band)
in an IT framework. Second one is the asymmetry in the persistence of shocks
to the inflation process. We argue that the cross-country differences among the
degree of asymmetry and adjustment process in our set of inflation-targeting
countries could be explained by the relative strength of these two drives. This
introductory section provides further motivation for these two different types
of asymmetries. The second section introduces the econometric methodology
built on these premises and presents a brief literature review.
The first motivation above; the asymmetric monetary policy response against
departures from the policy target, is based on two conjectures, as follows. First,
as Orphanides and Wieland (2000) argue, many inflation-targeting central banks
aim to keep inflation within a target rangerather than focusing on a point target.
Consequently, the policy response function of the central bank shows a non-lin-
ear behaviour depending on inflation being insideor outside of a specific zone:
As a consequence, if the policymaker assigns at least some weight
to output stabilization, the output objective will dominate at times
when inflation is within the zone but will recede in importance when
inflation is outside the zone. (Orphanides and Wieland, 2000).
According to this view, when the deviation in inflation from the target level
is above or below a certain threshold, central bank takes necessary actions to
take the inflation back to the target level.
2
As will be detailed in the second
section, exponential smooth transition autoregressive (ESTAR) model pro-
vides a suitable framework for modelling this kind of a response structure.
Our second conjecture is that, in addition to this kind of threshold behav-
iour, there is a further asymmetry in monetary policy response of central
banks against deviations of inflation from a pre-defined target level. Policy-
makers in inflation-targeting countries could be more biased against upwards
jumps in inflation rather than downwards movements. As the argument goes,
undershooting the inflation target does not affect the credibility of the infla-
tion-targeting central bank as much as overshooting. Moreover, the tendency
of central bank to focus on other objectives than inflation could be stronger
when inflation rate stays below the target level. Accordingly, the monetary
policy response would be more immediate and strong in case of a positive
deviation from the target level rather than its negative equivalent, provided
that the deviation is above a certain threshold.
3
2
Parkin (2013) argues that an important factor that could determine the central bank’s
stance on the trade-off between inflation volatility and output volatility within an inflation
targeting framework is the level of central bank independence.
3
Obviously, one would argue that a negative deviation should also raise concerns for
deflation spiral for a central bank. However, the historically high inflation rates in many
countries led to a perception in public mind that inflation would not go down as easily as it
goes up.
ASYMMETRIC BEHAVIOUR OF INFLATION 487
Scottish Journal of Political Economy
©2015 Scottish Economic Society
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